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ASIA The silk curtain is slowly closing on foreign investment

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CHINA Of all the steel producers to have emerged from China on the back of the country's incredible economic boom, Baotou Iron & Steel (Group) Co. Ltd. is likely to be one of the least familiar.

The company is a mid-ranking mill that until a couple of years ago was perhaps best known as one of China's top producers of rail. But Baotou Iron & Steel has grown rapidly in recent years, adding more than 2 million tonnes of crude steel output since 2005, although that is nothing spectacular in the context of the massive growth in Chinese output.

The relatively obscure mill has attracted the attention of two of the world's most important steel producers, Mittal Steel Co. NV, Rotterdam, and Shanghai Baosteel Group Corp., Shanghai, China, and has come to symbolize some of the noteworthy changes that are taking place in China.

Before it became the dominant global producer with its takeover of Luxembourg-based Arcelor SA, Mittal Steel entered into talks with Baotou Iron & Steel to buy a 49-percent stake in the Chinese company's listed arm. The talks came to nothing, with Baotou Iron & Steel saying earlier this year that Mittal Steel had backed away following its takeover of Arcelor. It's possible that the world's biggest steelmaker simply had other priorities, but it's equally possible that the Chinese government's increasing protectionism towards its steelmakers had a big role to play in the change of strategy.

The central government said in 2005 that it considered steel a strategic industry, and made it clear that it didn't welcome foreign control of any significant mills. The government doesn't always get what it wants where the steel industry is concerned—evidenced by continuing over-investment—but in terms of foreign investment, Beijing's word is law.

According to some market participants, Mittal Steel's retreat helped clear the way for Baosteel to make its move. China's top steelmaker has long been a favorite of the central government, and the restrictions on foreign investment have cleared the way for domestic consolidation.

Rumors of a tie-up between Baosteel and Baotou Iron & Steel have been floating around for some time, and strengthened in late April when a government minister pledged to promote the "unity" of the two companies.

That could have significant implications, not just for China but also for the shape of the global industry. Baosteel, which took control of another smaller mill, Bayi Iron & Steel Co. Ltd., earlier this year, could at a stroke leapfrog the Japanese and South Korean majors to become the world's second-biggest producer, behind only Arcelor Mittal.

China's regional rivals, such as Nippon Steel Corp. in Japan and Posco Ltd. in Korea, are looking to adapt to the new world order by enhancing the quality of their output in order to head off the flood of commodity-grade steel churned out by Chinese mills. They also are moving to shore up defenses against possible takeover bids, although interestingly it is Arcelor Mittal rather than any Chinese producer who is seen as the biggest threat in Tokyo and Seoul. China's exports, rather than the hostile intent of its producers, are what keep Asian steel executives awake at night.

If Chinese mills are focused on domestic mergers and acquisitions, as seems likely, this could actually help solve the problem of surging exports. China's top three producers, Baosteel, Tangshan Iron & Steel Co. Ltd. and Anshan Iron & Steel Group, accounted for less than 15 percent of total steel output last year. If that proportion can be raised to 30 percent or more by the end of the decade, then the amount of control the central government can exercise over production, and therefore exports, should increase.

It's far from certain that will happen, however. The fastest-growing segment of the Chinese industry is the privately owned mills, most of which are smaller producers that don't answer to Beijing.

Another challenge for Chinese consolidation is that many of the companies involved are less than enthusiastic about it. For example, the merger of Anshan Steel and Benxi Iron & Steel (Group) Co. Ltd. was announced with great fanfare in August 2005, but two years later the two companies are still operating as separate entities. On paper, the joint company, Anben Iron & Steel Group, is China's largest producer—but internal wrangling, together with the competing priorities of central and regional government agencies, are preventing the merger from being completed.

With this in mind, it's unclear whether top executives at Baotou Iron & Steel will have much say about whether they want to become an arm of Baosteel. But if Baotou Iron & Steel does get subsumed into Baosteel, its fate will illustrate one of the main trends in the recent history of the Chinese steel industry.

Western steelmakers who initially considered Chinese growth an investment opportunity have, on the whole, been rebuffed. The challenge now may be to find ways to adapt to that growth rather than be part of it.

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